Rising interest rates have certainly been on the minds of many bankers over the past year. The Fed has hiked the Fed Funds target rate eight times in its current effort to tighten monetary policy and the FOMC’s Dot Plot telegraphs several more rate hikes through 2020. With credit conditions generally strong, (despite some challenges in the housing and auto sectors) and deposit competition heating up, future regulatory exams will likely focus on ALL aspects of interest rate risk (IRR) management, including the independent review.
By now, all institutions should be aware of the existing regulatory requirement to perform periodic independent reviews of the IRR management process. These reviews are designed to provide a fresh set of eyes on institutions’ policies and procedures for identifying, measuring, monitoring, and controlling IRR. Over time, we have observed most institutions outsourcing this function to a third party, with the minority internalizing the review. All too often, independent reviews are completed solely for regulatory appeasement and the final deliverable may not provide a “value added takeaway” to enhance IRR management. This is something that all institutions deserve. Whichever route you choose, be sure to obtain the maximum value possible out of this regulatory requirement.
Through the years, Taylor Advisors has performed independent reviews for a variety of clients and we thought it would be helpful to outline some of the common issues and best practices that we have encountered.
Comprehensive Policy – A policy should be a document that provides both a framework to hold the institution accountable and a mechanism for business continuity. As such, policies should be regularly updated to account for any changes in IRR management practices and risk tolerances. Such practices could include reviewing the policy, evaluating appropriate risk limits specific to your institution, performing a back-testing analysis, and monitoring net income exposure. A policy should be able to provide a casual reader with a comprehensive understanding of the various practices for identifying, measuring, monitoring, and controlling IRR.
Customized Assumptions – “GIGO” (Garbage In, Garbage Out) is a common acronym used in computer programming and translates well to IRR modeling. Model output is only as accurate as the inputs and critical assumptions and, as such, attention should be paid to how your institution is developing assumptions. In some instances, generic industry assumptions may be reasonable, but over-reliance on these come at a cost of model accuracy. A number of companies are willing to provide comprehensive assumption studies, albeit many of them come at a cost. Occasionally, loan and deposit beta studies along with historic loan prepayment calculations can be performed internally, assuming the necessary data is available. Keep in mind, an important part of assumption development includes periodic stress-testing to monitor exposures should assets and liabilities behave differently versus history-based expectations.
Over-Reliance on GAP – GAP is the oldest and simplest metric for measuring IRR and, as such, has limitations. Over-reliance on GAP as the primary interest rate risk metric could be dangerous for several reasons. First, this tool can often mask the true interest rate risk position of an institution. Second, it can lead to “information overload” when GAP simulations and risk limits are compared with other, more pertinent, IRR data. Institutions should keep the primary focus on the earnings at risk simulations (both one and two year) and use the economic value of equity simulation to guide longer-term strategy and risk posturing.
Board Education – Outstanding regulatory guidance stresses the importance of knowledge and education for boards and management teams:
- Joint Agency Advisory – “Regulators remind boards of directors that they should understand and be regularly informed about the level and trend of their institutions’ IRR exposure.”
- Joint Agency Policy Statement – “Effective risk management requires an informed board, capable management and appropriate staffing.”
- FDIC Winter Insights Article – “A board and senior management team that administer effective policies and are well informed can better position their bank to sustain profitability and preserve capital as the interest rate environment changes.”
Periodic education and training is often overlooked but is vital to appropriately managing the balance sheet and IRR positions of an institution. Education should go beyond simply attending vendor conferences to review IRR concepts and key modeling techniques. Rather, a well-informed board and executive management team would grow and benefit most from periodic training to understand their institution’s key balance sheet positions (capital, liquidity, investments, etc.) and customized IRR training specific to their balance sheet. The old adage “knowledge is power” applies well here; the more knowledgeable your directorate is, the more competently they can direct the institution’s risk management and strategy.
In closing, independent reviews provide your institution with an opportunity to enhance your IRR risk management policies and practices. Institutions should take full advantage of this requirement and ensure that it is a value added exercise. Furthermore, IRR education and training is critical for the board to carry out its fiduciary duty to oversee the institution. Ask yourself the question: Do my board members have a good grasp of how we manage our balance sheet? If yes, congrats! If not, scheduling some education on balance sheet management by a trained professional could be beneficial. Having a strong IRR knowledge base can help to engage the directorate to provide more insight into loan and deposit pricing, to understand balance sheet mix implications on profitability and risk, and to determine which strategies provide superior long-term value.